Real Estate Investment Trust (REIT): What It Is And How To Profit
Andrew Dehan7-minute read
October 27, 2020
Have you been looking for a good reason to buy a monocle? Becoming a real estate investor is as good a reason as any. And real estate investment trusts (REITs) can be for anyone with a little money to invest.
This article will lay out what a REIT is, the different kinds of REITs and how to analyze them. You don’t have to have millions to own that apartment on Park Place. With REITs you can get the steady income of real estate without the risks involved in owning the physical property.
What Is A REIT?
A REIT is a company that operates as a trust. This trust oversees, funds and often owns a variety of profit-making properties. From hospitals to warehouses and apartments, REITs invest in a variety of real estate endeavors.
Unlike many other types of investments, REITs don’t appreciate at a high rate. That means that the value of what you own may not increase much over time. What REITs don’t offer in terms of capital appreciation, they make up for in a steady income for investors.
With REITs that are publicly traded, investors can get into real estate without investing in physical properties. This means their portfolio remains flexible, able to sell and buy other investments without being tied to a physical place. Investors refer to this flexibility is “liquidity.”
The IRS defines how REITs are formed and the guidelines they must follow. According to the IRS, to qualify as a REIT, an organization:
- Must be a corporation, trust, or association.
- Must be managed by one or more trustees or directors.
- Must have beneficial ownership (a) evidenced by transferable shares, or by transferable certificates of beneficial interest; and (b) held by 100 or more persons. (The REIT does not have to meet this requirement until its 2nd tax year.)
- Would otherwise be taxed as a domestic corporation.
- Must be neither a financial institution (referred to in section 582(c)(2)), nor a subchapter L insurance company.
- Cannot be closely held, as defined in section 856(h). (The REIT does not have to meet this requirement until its second tax year.)
Along with these requirements, REITs must have 75% of assets in treasuries, cash or real estate. Most of their income must come from rents, mortgage interest or the sales of real estate. And they must pay at least 90% of taxable income to shareholder dividends every year.
Types Of Properties
REITs specialize in investing in a variety of properties. These can include:
- Shopping malls
- Self-storage facilities
- Apartment buildings
- Office buildings
- Commercial real estate
- Industrial buildings
- Hospitals and medical offices
They generate income in a couple different ways, depending on the type of REIT. The first is that the REIT owns the property and collects rent. Another way they generate income is by funding the mortgages for companies buying these properties, collecting interest over the length of a loan.
REITs can be invested in in a few different ways. These include purchasing share of publicly traded REITs and investing in mutual funds and exchange-traded funds (ETFs).
One of the most common ways is through retirement funds. In October 2019, Reit.com published research showing that approximately 87 million American adults own REIT Stocks. Most of these are owned through tax deferred retirement accounts, like employer sponsored 401(k) plans.
9 REIT Types
There are many different types of REITs. You can break them down into three different categories that define them: how they’re held, how they’re traded and what types of property they deal with. Any REIT can be a combination of these three things.
Let’s break down these three types with examples of each.
REITs By Holdings
1. Mortgage REITs
Put simply, mortgage REITs (or mREITs) derive their income from interest on mortgages. They’re known for relatively high dividends. These trusts provide funding for mortgages, whether for residences or companies. MREITs fund mortgages either through mortgage origination or purchasing mortgage-backed securities.
MREITs can be publicly traded, publicly non-traded or privately held.
2. Equity REITs
Most REITs operate as equity REITs, so most of the time, when the market is referring to REITs, this is what they mean. These trusts generate income from renting real estate to tenants, from businesses to residents.
After paying expenses for operation, equity REITs pay out dividends to their shareholders on a yearly basis.
3. Hybrid REITs
Hybrid REITs contain both equity and mortgage REITs. They give investors more diversity, offering better protection from real estate market swings. They work with both income- and growth-oriented portfolios.
REITs By How Shares Are Bought And Sold
4. Publicly Traded REITs
These REITs trade on a stock exchange, such as Nasdaq or the New York Stock Exchange (NYSE). They’re liquid and are open to all types of investors. All that’s needed is a brokerage account.
Publicly traded REITs are the way most people invest in real estate.
5. Publicly Non-Listed REITs
These types of REITs are not listed on a public stock exchange. They’re less liquid, have minimum holding periods and have minimum investment requirements. However, they may be higher-quality and provide higher returns than a publicly listed REIT.
6. Private REITs
These investment types are not open to the public. They aren’t registered on the SEC and are only sold to institutional investors. While they have high minimum investments and are very hard to sell, they can offer much higher returns than public REITs.
REITs By Real Estate Type
7. Health Care REITs
These types of REITs specialize in properties related to health care. Whether it’s senior housing communities, research centers or medical office buildings, these types of REITs come with their own benefits and risks. They work best in a diversified portfolio where other investments aren’t subject to changes in healthcare policy or medical demand.
8. Commercial REITs
These are investment trusts that concentrate on commercial property. These can include everything from offices to warehouses to shopping malls. They often offer high returns than REITs but are subject to fluctuations in the economy. For instance, if businesses are no longer able to pay their rent due large problems, like COVID-19 or widespread wildfires, commercial REITs will suffer.
9. Residential REITs
These are REITs that own and operated rented residential properties. These can include units from single-family rentals to high-rise apartments. They are subject to changes in the housing market, such as changing interest rates and rising homeownership.
Unlike some other REITs, residential REITs are more recession-resistant. No matter the economic situation, people need to live somewhere. When times get hard, people stop going to the movies and buy cheaper goods so they can pay rent.
The Pros And Cons Of REIT Investing
As with any investment, REITs have upsides and downsides. Here we’ll weigh the pros and cons of these types of trusts.
Here are the benefits of REITs compared to other investments:
- Profit from real estate without property interaction – You receive many of the benefits of real estate without having to own and manage the investment property.
- Must pay at least 90% of taxable income to shareholders – This is a legal requirement defined by the IRS. These payments come to investors in the form of annual dividends.
- Generate steady income – Whether it’s an equity REIT collecting rent or a mortgage REIT collecting interest, these investments generate a regular, dependable income.
REITs also have cons when compared to other investments:
- Little capital appreciation – REITs don’t grow in value at the same rate as other investments.
- Taxed as income – The dividends you receive from REITs are taxable income. This can especially be a downside if they bump you up to another tax bracket.
- REIT fraud – This is particularly a problem with non-listed REITs. There are people out there creating REITs to scam people out of money.
How To Make Money On A REIT
There are a few different ways to analyze the value of a REIT. Here is a basic overview of terms to be familiar with and how they can be used to assess the investment.
Net Asset Value (NAV)
NAV is the total net value of the REIT. It’s calculated by taking the total value and subtracting the total value of the company’s liabilities. NAV is broken down per-share.
When comparing it to the total value, the percentage of a company’s liabilities is apparent, making it a useful tool in finding overvalued and undervalued investments.
Funds From Operations (FFO)
FFO refers to the income generated by a REIT. It’s used to measure the trust’s performance. It reflects the steady cash flow of the trust by excluding any spikes in income from property sales.
To calculate the FFO, add up the REIT’s net income, depreciation and amortization, then subtract any gains from property sales.
Adjusted Funds From Operations (AFFO)
Similar to FFO, AFFO takes it a step further. It subtracts recurring expenditures that are capitalized and amortized, as well as rents that have straight line depreciation.
AFFO was developed to more accurately determine a REITs performance in generating income and delivering dividends than an FFO measurement.
Top-Down And Bottom-Up Analyses
Top-down and bottom-up analyses are two ways to look at any investment and should be considered when looking at REITs. Top-down is the broader perspective of the two, looking at themes on a national level. A top-down analysis, given an aging demographic, may recommend investing in senior living real estate.
Bottom-up, on the other hand, focuses on specific companies. You say you want to invest in REITs with an emphasis on retirement communities, then you analyze those REITs. You get into the details of their history and how they’re run, along with how they’ve delivered on dividends.
Successful REIT investing requires top-down and bottom-up analyses.
Are REITs A Good Investment For You?
If you’ve ever wanted to live out your desire to be the Monopoly man, a REIT could be right for you. They’re more liquid than physical properties and can be a steady source of income. They are still subject to market forces and may not deliver on capital appreciation over the years.
Before making the plunge, do your research on the investment. A financial advisor could help you make REITs a part of your portfolio if they aren’t already. There’s a great value in investing in real estate, whether through stock or property ownership. Make sure you take the right steps to make your REIT work for you.
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